Booms, Bubbles and Bust in the US Stock Market

Why did US stock markets experience such a huge bubble in the 1990s? Why did Greenspan 'allow' the bubble to occur? Why did investors appear to act irrationally and indulge in such vehement speculations? Why the euphoria? This book examines the American stock market during one of its most intriguing periods. By turning his critical eye upon the rise of the stock market bubble during the 1990s boom years and its inevitable crash some years later, David L. Western has written a scholarly yet readable book. Providing historical background as well as solid statistical research, the book helps to explain the mysteries of the stock market in an authoritative manner. Advanced undergraduate and postgraduate and postgraduate students will find this to be an enlightening read, whilst readers with an interest in how the biggest economy in the world got things badly wrong will find this to be a book that remains useful as a reference for many years to come.

David L. Western is Senior Lecturer at Curtin Business School, Australia.

List of Figures

xi

List of Tables

xiii

Foreword

xiv

Acknowledgements

xvi

Introduction

1

(1)

Why the stock bubble?

1

(1)

From one bubble to another?

1

(1)

A unique set of circumstances?

2

(1)

How absurd were valuations?

2

(1)

Why did investors ignore warning signals?

3

(1)

Why did the stock bubble burst?

4

(1)

Why did Greenspan ignore `irrational exuberance'?

4

(1)

Greenspan and the markets

5

(1)

How costly was corporate governance failure?

6

(1)

The Fed's enemy: inflation or deflation?

7

(1)

What are the lessons from the 1929 bubble?

8

(1)

Japan's mess and deflation: what can the United States learn?

8

(1)

The massive policy push: powerful enough to create sustainable growth?

9

(2)

How fragile is the US recovery?

11

(1)

Where from here?

11

(1)

A bull or bear market rally?

12

(1)

The bubble era in US stocks

13

(18)

Introduction

13

(1)

Origins of the bubble

14

(2)

Why the stock bubble?

16

(1)

Stocks versus bonds

16

(3)

Absurd valuations

19

(1)

The bubble: geopolitical forces at work?

20

(2)

The bubble: underwritten by a stable bond market?

22

(1)

Debt, savings and switching

23

(1)

Warning signals: why not switch?

24

(1)

What of corporate earnings?

25

(3)

Similarities with 1929

28

(1)

Where from here?

29

(1)

Conclusion

29

(2)

The great bull run of the 1990s

31

(21)

Introduction

31

(1)

Macroeconomic background

32

(5)

The policy paradigm

37

(1)

Dip and recovery: 1990--1

38

(1)

The roaring Dow: 1992--3

39

(2)

The policy-induced correction: 1994--5

41

(2)

Up, up and away: 1996--7

43

(4)

Correction and a major recovery: 1998--2000

47

(4)

Conclusion

51

(1)

Valuation methods and investment strategies

52

(18)

Introduction

52

(1)

Portfolio choice

53

(2)

Diversification and risk

55

(2)

News: economic or financial?

57

(1)

Market efficiency

57

(1)

Investing over the life cycle

58

(1)

The fundamentals approach

59

(1)

The contrarian strategy

60

(3)

Serial correlation and mean reversion

63

(1)

Investment strategies

64

(2)

Financial fragility

66

(1)

Expectations, trading and timing

67

(1)

Conclusion

68

(2)

The bubble era: how rational?

70

(18)

Introduction

70

(1)

Biases in the one-way street

70

(6)

Where were the arbitragers?

76

(1)

Old benchmarks and turning points

77

(1)

Was it a speculative bubble?

78

(1)

The `New' new economy

79

(1)

The 1990s: a deviation from fundamentals

80

(2)

Wealth storage and far-sightedness

82

(1)

Greenspan's defense of the NASDAQ bubble

83

(2)

Domestic origins of the boom

85

(1)

Conclusion

86

(2)

The new economy: has it arrived?

88

(14)

Introduction

88

(1)

Productivity growth and the stock market

89

(1)

A rational bubble?

90

(1)

Old questions and old answers

91

(1)

The productivity slow down debate

91

(2)

Sources of productivity growth

93

(1)

The IT and communications revolution

94

(3)

IT and communications: drivers of productivity growth?

97

(1)

US government and productivity growth

98

(1)

Productivity growth: how permanent?

99

(1)

Productivity and the stock bubble

100

(1)

Conclusion

101

(1)

Governance issues: old and new

102

(13)

Introduction

102

(1)

Market versus government failure

102

(3)

Incentives and trade-offs

105

(1)

What are the challenging issues?

106

(2)

Wall Street in the 1960s: fresh challenges

108

(1)

Past pressure for regulation

109

(1)

The case of Enron

110

(1)

A dangerous incentive structure?

111

(1)

Regulatory reform and the Sarbanes-Oxley Act

112

(2)

Conclusion

114

(1)

The Federal Reserve: in unchartered waters?

115

(17)

Introduction

115

(1)

Ultimate objectives and trade-offs

116

(1)

The yield curve

116

(1)

The government environment

117

(1)

America's economic cruise speed: what guideposts?

118

(2)

Diagnosis of imbalances

120

(3)

Hitting targets: what policy mix?

123

(1)

What economic indicators?

124

(2)

Critics of the `Wrong Paradigm'

126

(1)

Canterbery's Vatican paradigm

127

(1)

Reputation and credibility of the Federal Reserve

128

(1)

The caterpillar market and fear of the Fed

129

(1)

Confessions of a central banker

130

(1)

Is the Fed secretive?

130

(1)

Conclusion

131

(1)

Shifting ground beneath the Federal Reserve

132

(17)

Introduction

132

(1)

Deregulation of the financial sector

132

(1)

Financial product innovation

133

(3)

Technology and innovation

136

(2)

The effectiveness of monetary policy

138

(2)

Target interest rates or monetary aggregates?

140

(1)

Does money affect output?

141

(1)

Channels of the monetary transmission mechanism

142

(2)

Does money affect stock prices?

144

(1)

Interest rates: how effective on output?

145

(1)

Interest rates: what affect on stocks?

146

(2)

Conclusion

148

(1)

Evaluating the Greenspan years: 1987--2004?

149

(16)

Introduction

149

(1)

Greenspan's background

150

(1)

Greenspan's economic philosophy

150

(2)

Greenspan and the markets

152

(4)

Sifting wheat from the chaff

156

(1)

Power to move the economy?

157

(1)

Mistakes in the Greenspan era?

157

(3)

Greenspan's two flagships

160

(1)

Flexibility: Greenspan's hallmark

161

(2)

Conclusion

163

(2)

The great asset price bubble of 1929

165

(13)

Introduction

165

(1)

Seeds of the bust in the 1920s

165

(2)

Damage to the real economy

167

(1)

Causes of the 1929 crash and depression

168

(7)

What were the triggers?

175

(1)

What lessons have we learnt?

175

(1)

Could history repeat itself?

176

(1)

Conclusion

177

(1)

Lessons from Japan's financial crisis

178

(18)

Introduction

178

(1)

Japan's old growth strategy

178

(2)

Weaknesses and seeds of destruction

180

(1)

Macroeconomic challenges

180

(1)

Policy levers

181

(1)

Why the asset price bubble?

182

(1)

Financial not economic constraints

183

(1)

Japan's asset price bubble: liquidity roots?

184

(1)

What of the export growth strategy?

185

(1)

Monetary policy failure

186

(1)

Monetary transmission mechanism: clogged pipes?

187

(1)

Fiscal policy failure

188

(2)

Krugman's insight

190

(1)

Japan's policy response: why so ineffective?

191

(1)

Lessons from Japan's financial crisis

192

(1)

A multi-pronged approach to recovery

192

(1)

Flow on effects from Krugman's solution

193

(1)

Lessons from Japan's stagnation

194

(1)

Conclusion

194

(2)

The Asian bubble and crisis

196

(16)

Introduction

196

(1)

Some commonalities

196

(1)

Financial origins of the bubble

197

(6)

Excess liquidity revisited

203

(1)

Why did the bubble burst?

203

(3)

The Asian crisis: why so sudden?

206

(1)

Stock market performances: post bubble

207

(3)

Conclusion

210

(2)

US stock markets: where from here?

212

(14)

Introduction

212

(1)

From one bubble to another?

213

(1)

What of currency instability?

213

(1)

The liberation of Iraq

214

(1)

Geopolitical forces

215

(2)

Synchronization and integrated markets

217

(1)

Why the US stock rally?

218

(1)

The powerful policy stimulus

219

(3)

The US economic recovery: where from here?

222

(1)

Lessons from the movie: Wall Street

223

(1)

Conclusion

223

(3)

Bibliography

226

(6)

Index

232

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Booms, Bubbles and Bust in the US Stock Market

Summary

Author Biography

Table of Contents

Supplemental Materials